Chapter 16 · Exchange rates and the balance of payments
Change in demand for a currency
Explain how exports, investment flows or expectations can shift demand for a currency. Show the effect on a floating exchange rate.
The economic idea
The exchange rate is the price of one currency in terms of another. The vertical-axis quotation matters: when it shows foreign currency per unit of domestic currency, an upward movement is an appreciation and a downward movement is a depreciation.
Demand for the domestic currency arises when foreigners purchase domestic exports, services or assets and when residents convert foreign-currency receipts. Supply arises when residents purchase imports, travel abroad or acquire foreign assets and when foreign investors repatriate funds.
In a floating system, the market rate adjusts to equate currency demand and supply. Appreciation is a market-driven increase in the currency’s value and depreciation a market-driven decrease. Revaluation and devaluation are official changes to a fixed exchange-rate parity.
A fixed exchange-rate system commits the monetary authority to an official rate or narrow parity. It must offset excess private demand or supply using foreign-exchange reserves, monetary policy, exchange controls or an eventual parity change.
A managed float allows market movement but uses intervention to influence the level or volatility of the rate. Sterilisation is a separate domestic transaction designed to offset the intervention’s effect on the monetary base.
Reading the movement from ER₁ to ER₂
“Quantity of domestic currency” is measured horizontally and records currency exchanged during a period.
“Exchange rate (foreign currency per domestic currency)” is measured vertically. With foreign currency per unit of domestic currency on this axis, a higher rate means one unit of domestic currency buys more foreign currency: it appreciates.
“D₁” slopes downward because a more expensive domestic currency makes domestic goods and assets dearer to foreign buyers; “S” slopes upward because foreign goods and assets become cheaper to residents as the domestic currency strengthens.
The market benchmark: E₁
“D₁” and “S” intersect at “E₁”. At “ER₁”, planned currency purchases equal planned sales at “Q₁”, so there is no pressure for the rate to change.
The new market position: E₂
Demand for the currency increases, shifting the curve from “D₁” to “D₂”. At “ER₁”, quantity demanded exceeds quantity supplied, creating excess demand. Competition to buy the currency raises the exchange rate, increasing quantity supplied along unchanged “S” until “E₂” is reached at “ER₂”. The currency appreciates.
From the nominal rate to the wider economy
An appreciation lowers the domestic-currency price of imports and raises the foreign-currency price of exports, ceteris paribus. It may reduce imported inflation and net exports, but the outcome depends on invoicing, elasticities, contracts, foreign income and firms’ pricing behaviour.
Begin with the buyer of the domestic currency
A foreign buyer paying for domestic exports may need to obtain domestic currency first. Greater demand for those exports can therefore increase demand for the currency at each exchange rate. A fall in foreign demand can have the opposite effect.
The shift shown identifies a change in currency demand, but does not prove which transaction caused it. Use the question’s context to explain the cause, then use the movement along “S” to explain how the market clears.
How the foreign-exchange market reaches the state shown
Identify the international transaction or expectation that changes the willingness to buy or sell the domestic currency.
Shift the relevant schedule from “D₁” to “D₂” while holding the other schedule constant.
At the original rate, identify excess demand or excess supply and explain why buyers bid the rate up or sellers accept a lower rate.
Continue until the active schedules intersect at “E₂”, producing “ER₂” and “Q₂”.
Common mistakes to avoid
- Do not name appreciation or depreciation until you have read the quotation on the vertical axis.
- An increase in exports shifts demand for the exporting country’s currency; it does not shift currency supply.
- A change in the exchange rate causes movement along currency demand and supply. A change in exports, imports, interest expectations or confidence shifts a schedule.
- Under a fixed rate, the market imbalance does not disappear by assumption; the central bank or another policy must absorb it.
- A nominal depreciation does not guarantee improved net exports, higher real GDP or a lower current-account deficit.
How to draw this diagram
- Title the diagram “Change in demand for a currency”. Label the horizontal axis “Quantity of domestic currency” and the vertical axis “Exchange rate (foreign currency per domestic currency)”.
- Draw D₁ first and label it clearly.
- Draw S next and label it clearly.
- Draw D₂ next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The two-curve diagram combines heterogeneous spot, forward, trade and financial transactions into one market.
- Expectations can change continuously and may move capital flows before trade quantities respond.
- The model holds foreign income, domestic income, interest rates, inflation and policy constant unless one is the stated cause of a shift.
- Official intervention may be sterilised and can be reinforced by interest-rate policy, controls or communication not shown on the graph.
- Nominal exchange-rate changes need not equal real exchange-rate changes when domestic and foreign prices also change.